The combined effect of commission and differential may also be seen in the Exchange's Monthly Investment Plan, designed to permit small investors to purchase shares on a regular basis. An investor investing $60 a month pays a total charge, commission and differential, of 7.35 percent of the value of the security purchased in accumulating a $10 stock, or 6.53 percent for a $50 stock. This combined cost of commission and differential is less than the normal mutual fund loading charge, but the former covers only the purchase of shares and is duplicated on a sale, while the mutual fund load normally covers both purchase and redemption.583

The Special Study has not evaluated the level of these charges. Its purpose is, rather, to point to some considerations involved in setting fair charges for odd-lot transactions, taking into account these rates as an aspect of the commission rate structure and the odd-lot customer's payment as both a commission and a differential. One question relates to the scope of the service for which the broker receives the commission. In the ordinary round-lot transaction, the member must pay another member to perform the brokerage functions of executing and clearing the transaction, if he does not perform them himself. But in the case of the odd-lot transaction, the member pays no commission for execution of the transaction, which is performed by the odd-lot dealer. The $2 odd-lot discount is apparently intended to compensate for this lowered cost, but in the illustration given above, the member saves $2.89 in floor brokerage.

A further question relates to the method employed in analyzing the cost of odd-lot transactions for rate-setting purposes. Cost data on a transaction basis are generally lacking. The Exchange's Special Cost Study noted

*that implementation of the proposed income and expense report form would provide data which could be used to refine average functional unit cost information as it may pertain to odd lots, round lots, small value transactions, etc.4

Despite the absence of such data in 1947, the report of the special committee of that year justified a sizeable increase in odd-lot commission rates because of the disparity between the ratio of odd-lot transactions to all transactions and the ratio of odd-lot income to all income. Its recommendation was the subject of the following comment by a member firm:

There is a serious fallacy, however, in such a method of cost accounting. Such reasoning implies that the elimination of odd-lot business would permit reductions in costs proportionate to the number of transactions handled. This simply would not happen. For November 1945 (5-week period) one of the months used in the association's study, [our firm] had a commission from odd lot transactions of $207,000. A firm of certified accountants in cooperation with our Internal Statistics Department, has estimated that [this member firm] could have eliminated less than $60,000 if we had handled no odd-lot business during that period. Consequently, had we eliminated odd-lot business and its related costs, our net profit would have been reduced $147,000.

The committee's rejoinder illustrates the importance of the pricing policy employed in creating a reasonable rate structure. In place

583 See ch. XI.B.

584 The Special Cost Study then qualified this statement by the assertion that " determination of average transaction costs for representative transactions will always be of limited significance and then only after consideration of both long- and short-volume trends for the period being considered.'

of the marginal cost approach employed by its critic, the committee emphasized the need for relying on average transaction cost: "Not to use a cost-per-transaction basis appears to us to ignore all fundamentals of cost accounting." Its view, of course, prevailed, and the commission rates in odd-lot transactions today appear to be based on their relationship to average cost and not to marginal cost.

There is no record of any study of the odd-lot commission in conjunction with the odd-lot differential; i.e., the total of commission and differential, to determine whether the cost of the transaction to the customer is reasonable. Rather, there appears to have been reliance upon the distinction between the costs in separate compartments. The discussion here and in part E of this chapter points to a need for further examination of the question and, at the least, a need for advice to the customer concerning the amount of the differential, as well as the commission, on each odd-lot transaction.

3. STRUCTURAL ASPECTS OF MEMBERS' RATE SCHEDULE

The description of the commission rate schedules in section 1 indicates how, in contrast to the unitary public schedule, the members' rate schedule establishes rate classifications distinguished by function, type and timing of activity. Since these rates seem to affect directly only members of the Exchange, there might be an inclination to conclude that they are of no concern to the Commission or the public, but such a conclusion would miss an important point. The rates charged by members to other members for the execution and clearance function are income to the member performing the functions and costs to the member for whom they are rendered. Thus, unreasonable rates can lead to unreasonably low or high earnings for the former, and have a corresponding effect on the costs and profits of the latter. Since the member who pays these "internal" rates generally requires the services in his capacity as an agent for the public, the price he pays becomes a cost of operation and ultimately affects the public commission rate schedule.

The public's interest in the members' schedule also stems from the method of its adoption. The votes of Exchange members on new commission rate schedules have consistently tended to be close, a circumstance mirroring the conflicting interests of floor brokers, specialists, floor traders, and commission houses, with the latter category further divided among large New York-based "wire" firms, smaller New York firms, and nonclearing, out-of-town firms. The analysis of the Exchange's membership in chapter XII reveals the relatively small proportion of members in firms whose primary business is with the public. Since there can be no assurance that the resolution of these different interests on the basis of relative strength in numbers will necessarily coincide with the public interest, the members' schedule must also be subject to regulatory review under the "reasonable" standard.

Setting and reviewing members' rates involves the determination of such questions as the reasonableness of member execution rates as compared to clearance rates; propriety of the specialist's receiving the entire floor brokerage when executing a limit order at the stipulated price rather than, as in the case of the Amex, use of a separate rate classification for this type of transaction; adequacy of the broker

age commission in respect of "not held" or discretionary orders; 585 justification of the differences between the rates paid by members for clearance of principal transactions and clearance of agency transactions; and reasonableness of present clearing charges generally in view of the economies which appear to have been achieved in the performance of this function.

Implicit in the existence of the members' rates is a "preference" for members over nonmembers. It is not necessary to challenge the validity of such a preference to consider the reasonableness of its amount. The relationship of member rates to cost was the Commission's major concern in the instance of the 1942 rate increase. The Commission determined at that time that

*** the clearance fees and commissions established by the New York Stock Exchange applicable to trading by members should cover the costs of the services received by those members *** [and] in the absence of specific information concerning the cost of such services, it [i.e., the Commission] would not now object to any action taken by the New York Stock Exchange consistent with this principle and *** any increase in fees and commissions should be taken on the responsibility of the Exchange and *** the Exchange should be advised that the Commission reserves all of its residual powers with respect thereto. The "absence of specific information concerning the cost of such services" does not seem to have been corrected. A minimum prerequisite for review of member or internal rates in terms of the cost of performing the underlying functions would seem to be a floor members' annual report, similar to the Exchange's Income and Expense Report for members in the public commission business, setting forth income, cost, and profit attributable to the performance of these internal Exchange functions. Also desirable for an effective review of the structure of such rates and their relationship to nonmember rates would be an understanding of accurate unit transaction costs for each function.

4. DETERMINATION OF THE LEVEL OF RATES

As indicated at the beginning of this part, although commission rates are "rules" of the respective exchanges, the Special Study has not felt called upon to consider their "adequacy" in the sense of whether the rate levels reflected in the present rules are "reasonable" within the meaning of section 19 (b) of the Exchange Act. The study has confined its review to the standards and methods used in arriving at given rate levels, and the following discussion should not be read as commenting in any way on the reasonableness of the dollar results at this time or at any time in the past.

It is important to reemphasize that, while the security commission business shares, with other businesses subject to rate regulation, the qualities of being "affected with the public interest" and of being limited to a standard of "reasonable" rates, the differences are perhaps more significant than the similarities, and the problem here is in many ways unique. Thus, the public utility normally possesses a franchise conferring upon it monopoly rights to furnish a service required by the public and also obligating it to furnish service to all who need it at reasonable prices. In contrast, though the auction market of the NYSE is a dominant unit in the structure of our capital markets,

586 See pt. D of this chapter.

about 500 member firms compete with each other for the business of the public to be transacted on the NYSE within the confines of the same commission rate schedule.586 Moreover, they compete with other investment media for the public's savings, and the Exchange itself competes as a marketplace with other markets, both for the listing of issues to be traded and for transactions in listed issues also traded on other exchanges (dually traded securities) or in the over-the-counter market.

There are other important economic differences. Public utilities generally are characterized by relatively high investment in fixed plant and equipment, while the security commission business is essentially a service business requiring relatively small capital investment but relatively high personnel costs. The income of utilities tends to be more stable than that of industry generally, while that of the security commission business fluctuates much more widely. These differences make it clear that the problem of "reasonable" rate level can be solved by no simple transfer of principles evolved in the field of utility regulation to the security commission business.

Finally, the structural characteristics of commission rates, discussed in sections 2 and 3, above, themselves create distinctions from typical utility rates. The minimum commission rates are probably unique in the degree to which they cover the basic service, brokerage, and also a range of ancillary services which firms may decide to offer and for which they may decide to make no extra charge. This feature alone would serve to make the problem of fixing reasonable rates of commission a highly specialized one wholly apart from the special procedural problems created by the statutory scheme which vests ratemaking initiative in the exchanges and a residual, albeit continuing, responsibility of oversight in the Commission.

It is also important to point out that, despite the competitive aspects discussed above, members of the NYSE are important factors in the regional stock exchanges and the over-the-counter markets, other than those over-the-counter markets in listed securities from which such members are generally excluded.587 On the other hand, trading in NYSE-listed securities is a major part of the business of most regional stock exchanges and is an increasingly important factor in over-thecounter markets. 588

This section briefly reviews (a) the history of rate changes since 1934, (b) the criteria which have been enunciated and the data to which they have been applied, and (c) the Commission's role in the fixing of "reasonable" rates.

a. Rate changes since 1934

Since the enactment of the Exchange Act in 1934, the NYSE has amended its nonmember commission rates five times. Each of these primarily involved an increase in the general level of rates, although limited structural changes were involved in some instances. Each of the increases was recommended by a special committee of the Exchange in a formal report which became the basis of the Exchange's proposal.

588 For a discussion of variations among member firms engaged in a commission business, see pt. A of this chapter.

587 See chs. VII.B and VIII.E.

588 See chs. VIII.D and VIII.E.

1938 increase.-In June 1937, the Exchange submitted to the Commission the report of a special committee, which had been conducting hearings for over 2 years, recommending a general increase in commission rates. The report pointed out that the industry had incurred sharp increases in costs while volume of trading had been decreasing, so that the "establishment of new conditions in the brokerage profession in the past 3 years now warrant, we believe, measures to obtain a fair return on a prudent standard of capital, equipment, and services." The Exchange's volume at that point had dropped to 1,492,000 shares daily from a high of almost three times that figure in 1929 (table VI-90).

In December 1937, the Commission advised the Exchange that— Whether or not these increases are appropriate or adequate, the Commission does not feel itself prepared to say. The statute does not make our approval a prerequisite to adoption, although it does give us a power of suggesting and compelling specified changes in rules and practices of exchanges *

It suggested the desirability of examining the entire question of "service charges" "589 with the statement that "this would necessarily entail a consideration of the financial situation of members of the Exchange with respect to the amount of capital invested, the risks incurred, the expenses of operation, and the profit or loss incurred." The Commission took no further action, however, and the increase became effective on January 3, 1938.

1942 increase. After the 1938 increase, the Exchange engaged the engineering firm of Stevenson, Jordan & Harrison to study costs of operation in the security commission business. The first of many such studies, it set a pattern for the future by classifying 19 "representative" participating firms on the basis of size and status as clearing or nonclearing firms, and stating income, costs, and profit as a percentage of both gross commission revenues and transaction units. A second such study, this time of 25 firms, gave rise in March 1941 to the Exchange's second proposal to increase commission rates, based on the sharp increase in operating costs since the previous rate change. Share volume had continued to drop and at this time was averaging only 619,000 shares daily.590

The Commission advised the Exchange that it could not approve the proposal, which sought to change the basis of the rate schedule from share value to value per round lot.591 The Commission then circulated to all members of the Exchange engaged in the security commission business a report form requiring a simple summary statement of income, expenses, and net profit or loss for the first 6 months. of 1941. After analysis of the returns, the Commission decided not to interpose objection to the increase in nonmember rates but to recommend an increase in rates for trading by members, which it felt should cover the cost of the services. The Exchange accepted this recommendation, and the new rates became effective March 16, 1942. 1947 increase.-Five years later the Exchange recommended, on the basis of a cost study of 54 firms conducted by the Association of Stock Exchange Firms, a change based on increases in operating costs,

599 In context, the use of the term "service charges" may have referred to commission rates generally and not the special charges discussed above. 500 See sec. 2.b, above.

501 Table VI-90 which presents average daily volume figures for the years 1925 through 1962 is opposite to the discussion of all of the rate increases.